Monthly Archives: June 2011

It may not have been the most felicitous choice of phrase, but Mark Halperin’s characterization of Barack Obama was not far off the mark, even if he did get suspended for it. The President is a dick, at least as far as his understanding of basic economics goes. Obama’s perverse fixation with deficit reduction uber alles takes him to areas where even George W. Bush and Ronald Reagan dared not to venture. Medicare and Social Security are now on the table. In fact entitlements of all kinds (excluding the myriad of subsidies still present to Wall Street) are all deemed fair game.

To what end? Deficit control and deficit reduction, despite the fact that at present, the US has massive excess capacity including millions of unemployed and underemployed, a negative contribution from net exports, and a stagnant private spending growth horizon. Yet the President marches on, oblivious to the harm his policies would introduce to an already bleeding economy, using the tired analogy between a household and a sovereign government to support his tired arguments. It may have been impolitic, but “dick” is what immediately sprang to mind as one listened incredulously to the President’s press conference, which went from the sublime to the ridiculous.

Discussion of government budget deficits often begins with an analogy to a household’s budget, and the President continues that horrible pattern of misinformation. Obama challenged the view that the government might side-step the debt ceiling constraint by just paying “interest on the debt” and said:

This is the equivalent of me saying, you know what, I will choose to pay my mortgage, but I’m not going to pay my car note. Or I’m going to pay my car note but I’m not going to pay my student loan. Now, a lot of people in really tough situations are having to make those tough decisions. But for the U.S. government to start picking and choosing like that is not going to inspire a lot of confidence.

Let’s state it again: households do not have the power to levy taxes, to issue the currency we use, and to demand that those taxes are paid in the currency it issues. Rather, households are users of the currency issued by the sovereign government. Here the same distinction applies to private businesses, which are also users of the currency. There’s a big difference, as all us on this blog have repeatedly stressed: Users of a currency do face an external constraint in a way that a sovereign issuer of its currency does not. This key point, which is persistently obscured in these discussions, is that if a government issues a currency that is not backed by any metal or pegged to another currency, then there is no reason why it should be constrained in its ability to “finance” its spending by issuing currency. Unfortunately, this elementary concept seems to have eluded the President and, presumably, the countless members of Congress involved in the debt ceiling negotiations. Typical is this statement from the President:

I do think that the steps that I talked about to deal with job growth and economic growth right now are vitally important to deficit reduction. Just as deficit reduction is important to grow the economy and to create jobs — well, creating jobs and growing the economy also helps reduce the deficit. If we just increased the growth rate by one percentage point, that would drastically bring down the long-term projections of the deficit, because people are paying more into the coffers and fewer people are drawing unemployment insurance. It makes a huge difference.

The President has the causation here totally backward. A growing economy, characterized by rising employment, rising incomes and rising capacity utilization causes the deficit to shrink, not the other way around. Rising prosperity means rising tax revenues and reduced social welfare payments, whereas there is an overwhelming body of evidence to support the opposite – cutting budget deficits when there is slack private spending growth and external deficits will erode growth and destroy net jobs. Even the IMF (in its October 2010 World Economic Outlook) recognized that fiscal consolidations, even though they tend to be accompanied by lower interest rates and lower exchange rates, are more frequently associated with economic contractions. Amazing to think that we’d ever see the day where the President outflanks the IMF.Expansionary fiscal consolidations are virtually impossible – the initial conditions, as well as the structure of the economy in question, must be right to support a stronger trade improvement, or a more aggressive spending path by domestic firms and households, which largely OFFSETS the impact of decreased government spending. Again, the key is looking at the impact of government spending reductions within the context of what the other two major sectors of the economy – private households and firms , and the external account (exports and imports) – are doing. In fact, if we had a balanced foreign sector (i.e. no trade deficit), there would be no way for the private sector as a whole to save unless the government runs a deficit. Without a government deficit, there would be no private saving. Yes, one individual can spend less than her income, but another would have to spend more than his income. It all has to balance in the end, as any accountant can tell you. To be fair to the President, most of his Republican counterparts are also “dicks.” Consider the comments of Senate Minority Leader, Mitch McConnell:

What Republicans want is simple: We want to cut spending now, we want to cap runaway spending in the future and we want to save our entitlements and our country from bankruptcy by requiring the nation to balance its budget. We want to finally get our economy growing again at a pace that will lead to significant job growth.

Like the President, McConnell evidently also feels that the US government can run out of dollars or, at the very least, computer keyboards to mark up or down the numbers in our national accounts. This is the only way one could make sense of his nonsensical bankruptcy comments. This perverse inability to distinguish between issuers and users of currencies is a disease which afflicts members of both parties and largely explains the willingness to hack away at what’s left of the American social welfare net (the President unilaterally disarming his party on Medicare before securing a single concession from the GOP). Change you can believe in! And the President wonders why his base is totally dispirited! Let’s be clear: the government creates ‘money’ whenever it spends; it destroys ‘money’ whenever it taxes. The issue, which the President should be out and front explaining, is whether or not its spending too much or taxing too little. With a rising unemployment rate, and a huge reserve of underemployed and disadvantaged workers, it is the height of insanity to cut spending overall which is what the US President is claiming is an important and urgent policy goal when there is so much idle productive capacity. Yet both the President and his Republican negotiators on the other side of this issue take it as a given that public debt per se is an unalloyed evil that should be eliminated as a long term policy goal. That is only possible if the external surplus is large enough. Otherwise, if you attempt to achieve that stage via fiscal cutbacks the policy strategy will undermine employment and growth. The upshot is that the budget deficit is likely to rise because of the slowing economy will undermine tax revenue.

Yes, it’s true that government deficits are not always good, or that the bigger the deficit, the better. The point the President and his equally misinformed economic advisors continue to ignore is that we have to recognize the macro relations among the sectors, much as a surgeon has to consider the impact of removing an organ from the patient in the overall context of how it will affect the rest of the body’s functioning. Blaming the deficit for our economic woes is akin to blaming the thermometer when it records a temperature from a patient suffering from the flu. They are both forms of quackery. To believe otherwise is to be, well, a “dick.” There’s no other word to describe it.

There were a large number of relevant comments and questions. I have done some cut and paste here and will deal with them in order.

Question: Is there any material difference between the sectoral balances in a currency and the sectoral balances issued in the national accounts for GDP purposes?

Answer: Here is my understanding: for the US there would be no (significant) difference as we use dollars in our stocks and our flows. Even if we buy foreign made output, we provide dollars that are exchanged for foreign currency. In other countries there could well be a significant portion of the economy that is denominated in a foreign (dollar) currency. Much of that could go unrecorded, of course. In that case the official accounts would be in domestic currency but if it were feasible we could also keep some accounts in dollars. All the macroidentities for this country would still apply for transactions that take place in dollars.

Q: Several comments were made about this statement: “No matter how much others might want to accumulate financial wealth, they will not be able to do so unless someone is willing to deficit spend.”

So do you consider inventory run up to be in the category of ‘willing’?

I’m thinking optimist makes perishable goods that in the end nobody wants to buy having somehow managed to persuade a bank to create the necessary money (possibly by having large valuable real thing to offer as collateral).

I also find it very confusing. A desire to accumulate wealth is very easy to realize – do not spend your income. Whenever anybody gets a paycheck technically the whole amount is saved. So saving or accumulation is realized by definition while spending requires action.

A: If a firm is producing “widgets” it does so to “realize” them in the form of money things—it wants to sell them to get a credit to its bank account If it cannot sell them, they are added to inventory and count in the GDP accounts (technically NIPA) as investment. There will be an offsetting flow which is saving. Within the private sector, the increase to investment equals the increase to saving—this activity has no impact on the overall private sector’s balance. But let us imagine that foreigners order those widgets; in that case, the firm gets to sell them (receiving a credit to its bank account); there will be no increase to domestic investment. Instead, exports have increased—there is a positive entry to the current account balance. Ignoring all other entries, the US domestic private sector gets a surplus on its balance (saving) while the foreign sector “deficit spends”.

I know this will not answer all possible questions that follow on from this. After we look at the “circuit approach” later in the MMP we will see how the firm financed its production of widgets and what the implication is for the firm if it fails to “realize” them in the form of sales for money things. You can think of the “saving” of the household sector as the counterpart to the undesired inventory accumulation by the widget manufacturer. The manufacture of the widget produces household income that can be consumed or saved; of course the firms hope workers never save—because that means lost potential sales. If households do save, widgets go to inventory as investment. The firm can then be in trouble—not able to cover its costs. But foreigners or the government can step in to fill the demand gap.

Q: I wonder about “a) Individual spending is mostly determined by income.” Is this important/necessary/useful for you exposition?

A: Of course, it is true that wealthier people can fairly easily spend even if their flow of income is zero—they can sell off assets or borrow against them. But for many households, it is “mostly” true that income determines spending. And it is common sense to most people. My bigger point, however, is that at the aggregate level we need to think about reversing the causation. My household’s income is mostly determined by my employer’s decision to spend on my wages and salaries. So household consumption really depends to a great extent on its income (so consumption is called “induced spending) but its income in turn comes from somewhere—largely spending by firms and governments on wages, profits, and interest. At that spending by firms is undertaken on the expectation of sales (expenditures by households or other firms). We then also have government and investment and exports that are at least to some extent “autonomous” to income (don’t depend on today’s income). Yes these are important issues both for explanation and for projections of economic performance. There is also a logical angle: a society can decide to spend more but it cannot decide to have more income (unless it spends more). Spending is thus logically prior.

Q: When somebody hands you a five dollar bill, you can’t spend (create an outflow) out of that instantaneous inflow. You can only spend out of your stock — whether it’s a Swiss bank account or the buck and a quarter you have in your pocket. Flows are strings of instantaneous events; stocks have existence and duration. You can only spend out of wealth, not out of income. Obvious, but a point of confusion out there in the world.

A: When my boss pays me my $5 wages, that is indeed an income flow—ie: $5 per hour, per week, per month, or per year. Flows occur over time (even if the time is short). I can accumulate my income (wages) flow in the form of green paper dollar notes—the flows accumulate to a stock of dollar bills. (Stocks are measured at a point in time. Now!, for example.) If instead I spend the wages as I receive them, that is a consumption flow financed out of wages flow. But if I save all my wages as accumulated stacks of dollar bills for a period of a year, and then at the end of the year I choose to run down my wealth by splurging on a new BMW, then I am dissaving (reducing stock of wealth) to finance consumption.

Note that if I accumulated BMWs as my wealth (rather than dollar notes) then I would first have to sell the BMWs before I could finance consumption. That is of course the advantage of accumulating “cash”—I don’t have to sell it before spending. So my exposition was not confused. You could say that it is rather arbitrary whether to count hoarding of $5 notes as a saving flow into my stock of wealth, that I then run down to finance consumption versus spending the $5 income flow to finance consumption. That is to say, as we collapse the time period toward an “instant” then the distinction between flows and stocks disappears. That seems to be what you are saying. An instantaneous flow reduces to a stock as time approaches zero. And that of course is correct, too.

Note that income can be received as a flow of claims (rather than green paper). I work all month long, accumulating wage claims on my employer. (Legally enforceable in court.) Then I finally get my paycheck and deposit it in my bank account. Now I spend down my deposit until my next paycheck. If we want to be technically wonky we would say you are receiving an income flow every day of the month that finances a consumption flow every day of the month. But as you say, the “payment” of the wage actually takes place on a single day as a credit to your bank account (increasing your stock of wealth). (Technically, the claim on your employer is converted to a bank deposit—usually a debit to your employer’s account and a credit to yours.) You could not “really” spend your wages (claims on your employer) until you got your paycheck—except by borrowing against the claims.

Q: My understanding of domestic government budget surpluses is that they merely destroy the dollars that earlier spending created. Isn’t it meaningless to suggest that a sovereign government “saves” its own fiat currency?

A: In practical terms, yes. In the US during the Clinton boom there was a projection that all outstanding US Treasury debt would be retired. This led to a mad rush at the Fed to figure out how the federal government could continue to run surpluses if there were no government IOUs out there to “destroy”. If we ever did get to that point, the only way the private sector could continue to run deficits against the government would be to surrender assets (not government IOUs) in payment. You’d have to turn over your car, house, bank account, and children to the government to pay taxes!! That is the logical result of a government surplus carried to infinity—government would accumulate infinite claims on you. And yes you are correct that sovereign government does not—cannot—“save” its own currency!

Q: “It is impossible for every individual in the private domestic sector to net save at the same time if that sector’s aggregate balance is zero” Sure, but the logic is not the one you and this post claim. It is savers who force deficit spending and not the other way. This is the reason why.

A: Takes two to tango, of course. I think I made that clear. But carrying on from above, at the aggregate level (at least) it makes more sense to say that spending “causes” income which in turn “causes” saving. Here is why. If I am credit worthy I can always decide to spend more (the bank takes my IOU, gives me its IOU, and I deficit spend). I cannot (easily) decide to have more income. I need income to save more. Still, it takes two to tango. Yes, if I have income I can decide to consume less and save more. That will have an implication on someone else’s income flow (since I am not buying her widgets). And that means undesired deficit spending (and perhaps inventory accumulation—as above).

Q: Could you provide an algebraic description of MMT and its prescriptions as part of the MMP?

New York’s adoption of marriage equality is the end of the beginning of the struggle on behalf of marriage equality. Ultimate success is never certain, but it is now highly likely though it will take over a decade to attain. The opposition to marriage equality has four crippling legal, social, and policy problems that I will briefly review. This article emphasizes an economic problem for the States barring marriage equality that will become intense given New York’s adoption of marriage equality and near certainty that California will soon do so.

The four legal, social, and policy problems that increasingly confront opponents of marriage equality include:

The brilliant strategy of “coming out.” Instead of the sinister unknown, over a hundred million Americans realized that they knew homosexuals who were exceedingly, boringly normal.

Much of the history of the West since the Enlightenment has been the recurrent broadening of the concept of “us.” We continue to transfer members of the hated and feared “other” into the category of “us” to whom we owe respect and care. Increasingly, those who grew up in a Western culture include homosexuals as “us.”

The opponents of marriage equality have lost the young. Overwhelmingly young conservatives are embarrassed and amazed at their older counterparts’ homophobia. Strong majorities of younger people support marriage equality. The present is already untenable for the opponents of marriage equality in many blue states – the future is terrifying.

The opponents of marriage equality have no arguments that will convince the unconvinced. Worse, their inability to come up with any convincing argument as to why marriage equality would harm society has led them to base their policy arguments on their prejudices – exposing and focusing attention on those prejudices. This is why, when writing to friendly audiences, opponents of marriage equality have emphasized the vital need to avoid any trial at which they would have to make and defend a claim that marriage equality harms society. They describe the effort to defend such a claim in Hawaii as a “disaster.” Instead of the sin that dares not speak its name, we have the indefensible prejudice that dares not be tested in any court. Here is the link to my prior column explaining this point.

In that article I also quote Gerard Bradley with regard to the economic dynamic that is the focus of this column.

“What then is to be done? Conservatives must hold the defensive lines — in state courts, in legislatures, in corporate America — as best they can. These efforts will come to naught, however, if the [Supreme] Court stays its course.”

The problem with Bradley’s strategy is “corporate America.” Corporate America will provide the impetus for ending state opposition to marriage equality. Recent articles have explained the strong role that business elites played in achieving the passage of New York’s marriage equality law. The CEOs who helped produce the passage were not motivated by economics. Their motivation arose from the four legal, social, and policy factors that I discussed. They had homosexual family members and understood the demonization that their kin faced and the pain of denying them the right to marry the life partner they loved. They believed that the denial of marriage equality was inhumane, unethical, and intolerable.

The rise of CEOs who are strongly motivated to be politically active in defense of marriage equality was a critical development in New York. It is likely to be replicated in some of the bluest states, particularly California. Even if the decision overturning California’s Proposition 8 is reversed there will be a prompt introduction of a proposition to overturn Proposition 8. Opinion in California has continued to swing to towards greater majority support for marriage equality since the Passage of Proposition 8. The role of pro-marriage equality CEOs in countering the LDS’ funding of the anti-marriage equality effort is likely to provide an extra margin of victory at the polls.

The political attraction of demonizing homosexuals will continue for years. Opponents of marriage equality will continue to introduce laws attacking it in the hopes of raising the saliency of the issue in order to increase the turnout by voters who are most strongly opposed to equality. There will be a series of legislative mixed legislative wins and losses on marriage equality. Losses will likely dominate for several years. But here is where the second aspect of economics and corporate America will prove decisive.

The bluest states have enormous populations and their economies are disproportionately large. They are home to tens of thousands of multinational and multistate businesses that have sophisticated pension and benefit provisions. The states that bar marriage equality will become increasingly unattractive places for many of these businesses. Regardless of the nature of their laws, states that deny marriage equality will become nightmares for these businesses if the states attempt to deny full faith and credit to the bluest states’ marriage equality laws. Executives and professionals who are homosexuals will either refuse to relocate to hostile states (damaging both the business and states denying marriage equality) or they will relocate and (often) live out and proud. That will lead to recurrent national publicity about intolerance. Their employers will either back them or fail to do so. Either response will only increase business pressure on the states refusing to respect marriage equality. Businesses and professional firms located in the diminishing pool of states that prohibit marriage equality will find it more difficult to recruit and will increasingly view their location as a competitive disadvantage.

Religious opponents of marriage equality consider it deeply unfair that most supporters of marriage equality view their opposition as bigoted, but that is the reality. Supporters of marriage equality will be repeatedly energized by each act of intolerance against same sex couples who end up living in states barring marriage equality. They will demand that businesses make a choice and they will demand that associations refuse to meet in states that are hostile to equality. As the number of states adopting marriage equality grows – and it will – the third economic pressure on businesses, and by businesses, in favor of equality will grow.

Arizona’s refusal to honor the Martin Luther King holiday offers an example of how acute this third economic pressure can become as the ranks of states barring marriage equality diminish. Arizona rescinded recognition of the holiday after it elected an ultra conservative Governor. Arizona voted to refuse to reinstate recognition of the holiday in 1990. That action led the NFL to move the Super Bowl from Arizona to the Rose Bowl in Pasadena, California. Arizona became a national embarrassment because its refusal was widely perceived as the product of bigotry. Arizona businesses demanded that the State stop this insanity. Prominent Arizona politicians like Senator McCain flipped their position and demanded that the state recognize the holiday. The question we will face, though it may take two decades, is which State wishes to reprise Arizona’s starring role as the symbol of intolerance? The time has come to start the betting pool to predict which State will be the last to abandon laws forbidding marriage equality.

Bovard shows no awareness of criminology, but what he described was the creation of a criminogenic environment. A criminogenic environment has such perverse incentives that it produces widespread crime in a particular field of activity. Non-criminologists frequently have difficulty believing that fraud can become common. They often believe that fraud can only arise among “a few rotten apples.” This view is naïve and crimionological research falsified the claim over a half century ago. Bovard is correct, therefore, that fraud can become common in an industry. This is particularly true if fraud produces a “Gresham’s dynamic.” George Akerlof explained this point over 40 years ago in his famous article on a market for “lemons” (1970).

“[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.”

Bovard purports to be a libertarian, yet he ascribes the creation of the criminogenic environment in food stamps to the three “de’s” – deregulation, desupervision, and de facto decriminalization. He is also upset that the federal government, in the context of food stamps, has failed to sufficiently distort consumer decision making. I address his substantive position on food stamps in another column.

This column explains his argument as to how the three de’s created a criminogenic environment in food stamps and shows how his reasoning would compel him to demand the end of the far more powerful and destructive criminogenic environments that drove the Great Recession (and the second phase of the S&L debacle and the Enron-era accounting control frauds).

The first element Bovard cites as producing a criminogenic environment is deregulation.

“Thirty-five states have abolished asset tests for most food-stamp recipients. These and similar “paperwork reduction” reforms advocated by the United States Department of Agriculture (USDA) are turning the food-stamp program into a magnet for abuses and absurdities.”

The second element he cites is de facto decriminalization due to the Obama administration’s near indifference to fraud.

“The Obama administration is far more enthusiastic about boosting food-stamp enrollment than about preventing fraud.”

Bovard argues that desupervision led to de facto decriminalization.

“The USDA’s Food and Nutrition Service now has only 40 inspectors to oversee almost 200,000 merchants that accept food stamps nationwide. The Government Accountability Office reported last summer that retailers who traffic illegally in food stamps by redeeming stamps for cash or alcohol or other prohibited items “are less likely to face criminal penalties or prosecution” than in earlier years.”

Bovard is implicitly raising the danger of a Gresham’s dynamic among retailers. Large, fraudulent retailers can obtain vastly more from food stamp fraud than can recipients. An honest retailer cannot compete against a large, fraudulent retailer. This turns market forces perverse and can drive honest retailers out of business. Fraud begets fraud.

Bovard appears to recognize that vigilant regulation is essential to successful fraud prevention and prosecution. When the regulators do not make anti-fraud efforts a priority the prosecutors are so overwhelmed that the criminal justice system breaks down. He cites the example of Wisconsin.

“The Wisconsin Policy Research Institute concluded: “Prosecutors have simply stopped prosecuting the vast majority of [food-stamp] fraud cases in virtually all counties, including the one with the most recipients, Milwaukee.””

In criminology, we refer to this as a “system capacity” problem. Bovard argues that the desupervision has effectively destroyed the capacity of the system to respond to the “crime wave” produced by the criminogenic environment. Bovard concludes that the criminogenic environment was inevitable because cheaters can profit with greatly reduced risk of prosecution.

Environments become intensely criminogenic when the federal government engages in the three “de’s” and preempts state anti-fraud efforts. This was an infamous feature of the Bush administration’s response to the fraudulent mortgage lenders, and Bovard argues that the Obama administration is intensifying a criminogenic environment in food stamps by following similarly fraud-friendly policies.

“The Obama administration is responding by cracking down on state governments’ antifraud measures. The administration is seeking to compel California, New York and Texas to cease requiring food-stamp applicants to provide finger images.”

So, how much does the food stamp fraud cost? Bovard does not provide the published estimates, but notes that 44 million Americans are recipients of food stamps at a total cost of $77 billion, or under $2000 per recipient. Individual frauds, therefore, obtain relatively small proceeds. Fraudulent retailers are the ones who are enriched by food stamp fraud. Bovard, however, concentrates entirely on fraudulent recipients and several corrupt public officials.

The GAO estimated, prior to the adoption of electronic benefit transfers (EBT) that food stamp trafficking represented 3.7% of annual benefits. Food stamps are now paid through EBT. This has greatly reduced the incidence of fraud by recipients, in some studies by an estimated 75-81 percent. Whitmore, Diane. “What are Food Stamps Worth?” (July 2002: p. 6 & n. 5).

Bovard missed the real food stamp crime wave (in terms of a much higher incidence of fraud) that peaked over a decade ago.

What we need now is to get Bovard and the Wall Street Journal to apply this same reasoning and passion about the dangers of the three “de’s” producing intense criminogenic environments to the three “de’s” that produced our recurrent, intensifying financial crises. My prior columns have explained at length how the three “de’s” produced the criminogenic environment that drove the “epidemic” of accounting, securities, mortgage, and appraisal fraud that hyper-inflated the bubble and led to the Great Recession. Bovard’s column was the most e-mailed WSJ article for two days. Food stamp fraud is important and Bovard’s rhetoric stirred the WSJ readership to rage. The accounting control frauds that drove the S&L, Enron era and ongoing crises are massively greater and more destructive and they involve our most elite CEOs becoming spectacularly wealthy at the expense of the public. The incidence of banking and mortgage fraud is far greater than food stamp fraud. The direct dollar losses due to these frauds are massively greater than food stamp fraud. The moral culpability and the financial gain of the CEOs who led the accounting control frauds are incomparably greater than that of a typical fraudulent food stamp recipient. The typical fraud consists of a recipient who is actually eligible for food stamps because she is impoverished selling some of those stamps to obtain income to purchase non-food items. Those non-food items can range from paying the rent and health care costs to illegal drugs. The systemic damage caused by the fraudulent CEOs – the Great Recession – has no counterpart in the food stamp context.

Bovard’s column allows us to test two rival theories. Hypothesis one: Bovard and the WSJ readers were enraged that the three “de’s” produced a criminogenic environment and led to a “crime wave” of fraud because they are enraged by fraud and the theoclassical dogmas that lead us to repeatedly adopt the three “de’s” despite the recurrent disasters they cause. Hypothesis two: Bovard and the WSJ readers were enraged by fraud by poor people and refuse to apply the same logic and moral outrage to the vastly greater and more damaging crimes led and generated by elite financial CEOs. Instead, they will blame “the government” and make excuses for the elite frauds. My bet is on the second hypothesis, but I hope to be proven wrong.

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In Blog #2 we introduced the basics of macro accounting, and in Blog #3 we took a break from accounting to take a look at the rise and fall of the Goldilocks economy in the US. Thus, we applied our sectoral balance identity to the case of the US. In today’s blog we will go a bit deeper into the accounting, looking at the relation between flows (deficits) and stocks (debts). To avoid making mistakes we need to make sure that we have “consistency” between our flows and our stocks. We want to make sure that all spending and saving comes from somewhere and goes somewhere. And we must make sure that one sector’s surplus is offset by a deficit in another sector. This is a lot like keeping track of the scores in a baseball game, and in fact most financial “scores” really are electronic entries in the modern world.

We will also try to say something about causation. It is not sufficient to say that at the aggregate level, the private balance plus the government balance plus the foreign balance equals zero. We would like to be able to understand why the private sector balance was negative during the Clinton Goldilocks years while the government balance was positive—how did we get to that point, and what sorts of processes did it induce. Obviously that is necessary before we can really analyse the situation and formulate policy. Unlike the macro accounting identity (which must be true), it is not possible to say with certainty what causes a particular sector’s balance. It is quite easy to say that if the government runs a surplus and if the foreign balance is positive (foreign sector spends less than its income) then the domestic private sector must by accounting identity be negative (running a deficit). It all must sum to zero.

Explaining why the private sector had a deficit during the Goldilocks years is harder; it is even harder to project if and for how long that deficit would continue. I already made clear in Blog 3 that I got the timing wrong—private sector deficits continued for about 4 years longer than I expected. Projections are darned hard to get right—if they were easy, MMTers would all make lots of money placing bets on outcomes. Another way of stating this is to say that a good understanding of MMT does not give one any monopoly on explanations of causation. We must not be overly confident. As the late and great Wynne Godley used to put it, he did not make forecasts, rather, he made contingent projections.

For example, carrying on with the work of Godley, the Levy Economics Institute (www.levy.org) makes such projections. Typically it begins with CBO (Congressional Budget Office) projections of the path of government deficits and of economic growth over the next few years. CBO projections are largely determined by current law (ie: laws determining government spending and taxing, as well as mandates over deficit reduction). However, the CBO’s projections are not stock-flow consistent and do not adopt the three sector balances approach (this used to drive Godley crazy). In other words, they are incoherent. But given projections over the government balance and GDP growth as well as empirical estimates of various economic parameters (propensity to consume and import, for example), one can produce a stock-flow consistent model that produces the implied sectoral balances as well as path of debt. The Levy Institute often finds that economic growth rates (for example) plus government deficit projections used in CBO forecasts imply highly implausible balances in the other two sectors (domestic private and foreign) as well as private debt ratios. To do that kind of analysis, you must go beyond the simple accounting identities.

Deficits -> savings and debts -> wealth. We have established in our previous blogs that the deficits of one sector must equal the surpluses of (at least) one of the other sectors. We have also established that the debts of one sector must equal the financial wealth of (at least) one of the other sectors. So far, this all follows from the principles of macro accounting. However, the economist wishes to say more than this, for like all scientists, economists are interested in causation. Economics is a social science, that is, the science of extraordinarily complex social systems in which causation is never simple because economic phenomena are subject to interdependence, hysteresis, cumulative causation, and so on. Still, we can say something about causal relationships among the flows and stocks that we have been discussing in the previous blogs. Some readers will note that the causal connections adopted here follow from Keynesian theory.

a) Individual spending is mostly determined by income. Our starting point will be the private sector decision to spend. For the individual, it seems plausible to argue that income largely determines spending because one with no income is certainly going to be severely constrained when deciding to purchase goods and services. However, on reflection it is apparent that even at the individual level, the link between income and spending is loose—one can spend less than one’s income, accumulating net financial assets, or one can spend more than one’s income by issuing financial liabilities and thereby becoming indebted. Still, at the level of the individual household or firm, the direction of causation largely runs from income to spending even if the correspondence between the two flows is not perfect. There is little reason to believe that one’s own spending significantly determines one’s own income.

b) Deficits create financial wealth. We can also say something about the direction of causation regarding accumulation of financial wealth at the level of the individual. If a household or firm decides to spend more than its income (running a budget deficit), it can issue liabilities to finance purchases. These liabilities will be accumulated as net financial wealth by another household, firm, or government that is saving (running a budget surplus). Of course, for this net financial wealth accumulation to take place, we must have one household or firm willing to deficit spend, and another household, firm, or government willing to accumulate wealth in the form of the liabilities of that deficit spender. We can say that “it takes two to tango”. However, it is the decision to deficit spend that is the initiating cause of the creation of net financial wealth. No matter how much others might want to accumulate financial wealth, they will not be able to do so unless someone is willing to deficit spend.

Still, it is true that the household or firm will not be able to deficit spend unless it can sell accumulated assets or find someone willing to hold its liabilities. We can suppose there is a propensity (or desire) to accumulate net financial wealth. This does not mean that every individual firm or household will be able to issue debt so that it can deficit spend, but it does ensure that many firms and households will find willing holders of their debt. And in the case of a sovereign government, there is a special power—the ability to tax–that virtually guarantees that households and firms will want to accumulate the government’s debt. (That is a topic we pursue later.) We conclude that while causation is complex, and while “it takes two to tango”, causation tends to run from individual deficit spending to accumulation of financial wealth, and from debt to financial wealth. Since accumulation of a stock of financial wealth results from a budget surplus, that is, from a flow of saving, we can also conclude that causation tends to run from deficit spending to saving.

c) Aggregate spending creates aggregate income. At the aggregate level, taking the economy as a whole, causation is more clear-cut. A society cannot decide to have more income, but it can decide to spend more. Further, all spending must be received by someone, somewhere, as income. Finally, as discussed earlier, spending is not necessarily constrained by income because it is possible for households, firms, or government to spend more than income. Indeed, as we discussed, any of the three main sectors can run a deficit with at least one of the others running a surplus. However, it is not possible for spending at the aggregate level to be different from aggregate income since the sum of the sectoral balances must be zero. For all of these reasons, we must reverse causation between spending and income when we turn to the aggregate: while at the individual level, income causes spending, at the aggregate level, spending causes income.

d) Deficits in one sector create the surpluses of another. Earlier we showed that the deficits of one sector are by identity equal to the sum of the surplus balances of the other sector(s). If we divide the economy into three sectors (domestic private sector, domestic government sector, and foreign sector), then if one sector runs a deficit at least one other must run a surplus. Just as in the case of our analysis of individual balances, it “takes two to tango” in the sense that one sector cannot run a deficit if no other sector will run a surplus. Equivalently, we can say that one sector cannot issue debt if no other sector is willing to accumulate the debt instruments.

Of course, much of the debt issued within a sector will be held by others in the same sector. For example, if we look at the finances of the private domestic sector we will find that most business debt is held by domestic firms and households. In the terminology we introduced earlier, this is “inside debt” of those firms and households that run budget deficits, held as “inside wealth” by those households and firms that run budget surpluses. However, if the domestic private sector taken as a whole spends more than its income, it must issue “outside debt” held as “outside wealth” by at least one of the other two sectors (domestic government sector and foreign sector). Because the initiating cause of a budget deficit is a desire to spend more than income, the causation mostly goes from deficits to surpluses and from debt to net financial wealth. While we recognize that no sector can run a deficit unless another wants to run a surplus, this is not usually a problem because there is a propensity to net save financial assets. That is to say, there is a desire to accumulate financial wealth—which by definition is somebody’s liability.

Conclusion. Before moving on it is necessary to emphasize that everything in this blog (as well as Blog #2) applies to the macro accounting of any country. While examples used the dollar, all of the results apply no matter what currency is used. Our fundamental macro balance equation,

will strictly apply to the accounting of balances of any currency. Within a country there can also be flows (accumulating to stocks) in a foreign currency, and there will be a macro balance equation in that currency, too.

Note that nothing changes if we expand our model to include a number of different countries, each of which issues its own currency. There will be a macro balance equation for each of these countries and for each of the currencies. Individual firms or households (or, for that matter, governments) can accumulate net financial assets denominated in several different currencies; vice versa, individual firms or households (or governments) can issue net debt denominated in several different currencies. It can even become more complicated, with an individual running a deficit in one currency and a surplus in another (issuing debt in one currency and accumulating wealth in another). Still, for every country and for every currency there will be a macro balance equation.

OK that is enough for this week. Can I remind commentators and questioners that this is a Primer. We will collect questions and comments until Wednesday and then post a response. We appreciate comments and questions directly related to this blog. We really do not want comments from those who have already examined and rejected MMT.

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It was obvious to those who understand Modern Money Theory that the set-up of the European Monetary Union was fatally flawed. We knew that the first serious financial and economic crisis would threaten its very existence. In a sense, it was from the beginning much like the US in 1929, on the eve of the Great Depression—with excessive lender fraud, household and business debt, and a boom that had run on too long. Anything could have set off the crisis that followed—just as discovery that Greece had been cooking its books sealed Euroland’s fate. And like the US post-1929, Euroland has struggled to understand and to deal with the crisis. Meanwhile, it is slipping into another great depression.

Many economists and policy-makers—even fairly mainstream ones—have come to recognize that the barrier to resolution is the inability to mount an effective fiscal policy response. And that is because there is no Euro-wide fiscal authority. Hence, the half-measures undertaken by the ECB and other authorities to put band-aids on the debt problem.

To be sure there is a conflict among authorities over the solution—given absence of a fiscal authority. Many want to impose austerity—equivalent to medieval blood-letting. These argue that the real problem is the lack of self-discipline in the periphery countries. Note that this view is shared by the elites in those countries! Many of them would be happy to throw their countries into deep depressions that wipe out all resistance to wage-cutting and slashing of all social programs that benefit working people. That is always the preferred solution of unenlightened elites. Through this method, wage costs in the periphery nations can be cut, making production more competitive.

This of course is also the position of the most powerful member of the EU. Prudent Germany had held wages in check over the past decade while ramping up productivity. As a result, it became the low cost producer in Europe and can even go toe-to-toe and win against Asia. Mind you, not in the production of cheap labor intensive output, but where it really counts in the high value added export sector.

And this view is also common among working classes in the central countries—that share the view of periphery populations as lazy and over-rewarded. While untrue, what is most shocking about this attitude is that if the blood-letting and crushing of wages in the periphery actually does work, the factories will be moved out of Germany seeking lower cost workers. In other words, success in the periphery would shift the burden back to Germany’s workers, who would have to accept lower wages to compete. That will be fueled by job losses if Germany cannot find sales outside the EU that will be lost as the periphery nations fall farther into depression. The result will be a nice little rush to the bottom, benefiting Europe’s elite. How nice.

To be sure, I do not think there is a snowball’s chance in hell that the EU will squeeze sufficient blood out of the Greeks (and Spanish and Italians and Irish and Portuguese) for this to work. What actually makes far more sense is to raise German wages—to achieve competitiveness within the EU by leveling up. But that snowball does not have a chance, either, because Germany is looking far outside the borders of Europe—and mostly in an eastern direction. As a result, it will remain focused on cutting its own labor costs—so the periphery nations will never catch Germany on the way down.

That leaves two alternative approaches. First, continued debt restructuring, ECB purchases through the back door (allowing central banks to buy the debt), guarantees, and lending. The hope is that the financial institutions holding all the periphery government debt can either move it off their balance sheets, or use the American method of “extend and pretend” to avoid recognizing the institutions are insolvent. The problem is that almost all the economic data in recent weeks are bad—almost globally—and that makes it likely there will be some financial hiccup somewhere that will spread as quickly through financial markets as it did in the Global Financial Crisis of 2007.

Many European banks will be recognized to be hopelessly insolvent—with PIIG government debt only adding to the problem. Further, the ECB legitimately worries about the “precedent” and “incentive effects”. This is not really a matter of rules governing what the ECB can do—it has leeway much as the Fed has to intervene in a crisis to essentially buy or lend against virtually any type of asset. It has to do with what the ECB sees to be its independence. Markets would view a US-style bail-out of the European financial system (and by extension, guaranteeing individual government debts) as a loss of its independence. In truth, the ECB already gave that up, but clings to the hope it can somehow get its virginity back.

The third approach is to create the necessary fiscal authority. This would allow the ECB to stick to monetary policy, while giving a European Treasury the purse strings to deal with the crisis. I’ve been arguing since 1996 that is really the only way to make the EU project viable. The economics behind that is simple, adopted in developed countries everywhere. Indeed, the US is effectively an American Monetary Union (AMU) but one properly set up with both a central bank and a treasury. However for political reasons, that ain’t going to happen in the EMU. We are actually further away from that than we were in 1996 because the crisis has increased hostility among the members. No one wants to cede power to the center.

Well, none of those is going to work. What is left? Exiting the union.

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Bill Gross, co-founder of Pacific Investment Management, recently advocated for an employer of last
resort program:

In the end, I hearken back to revered economist Hyman Minsky – a modern-day economic godfather who predicted the subprime crisis. “Big Government,” he wrote, should become the “employer of last resort” in a crisis, offering a job to anyone who wants one – for health care, street cleaning, or slum renovation. FDR had a program for it – the CCC, Civilian Conservation Corps, and Barack Obama can do the same. Economist David Rosenberg of Gluskin Sheff sums up my feelings rather well. “I’d have a shovel in the hands of the long-term unemployed from 8am to noon, and from 1pm to 5pm I’d have them studying algebra, physics, and geometry.” Deficits are important, but their immediate reduction can wait for a stronger economy and lower unemployment. Jobs are today’s and tomorrow’s immediate problem.

The fight for Europe’s future is being waged in Athens and other Greek cities to resist financial demands that are the 21st century’s version of an outright military attack. The threat of bank overlordship is not the kind of economy-killing policy that affords opportunities for heroism in armed battle, to be sure. Destructive financial policies are more like an exercise in the banality of evil – in this case, the pro-creditor assumptions of the European Central Bank (ECB), EU and IMF (egged on by the U.S. Treasury).

As Vladimir Putin pointed out some years ago, the neoliberal reforms put in Boris Yeltsin’s hands by the Harvard Boys in the 1990s caused Russia to suffer lower birth rates, shortening life spans and emigration – the greatest loss in population growth since World War II. Capital flight is another consequence of financial austerity. The ECB’s proposed “solution” to Greece’s debt problem is thus self-defeating. It only buys time for the ECB to take on yet more Greek government debt, leaving all EU taxpayers to get the bill. It is to avoid this shift of bank losses onto taxpayers that Angela Merkel in Germany has insisted that private bondholders must absorb some of the loss resulting from their bad investments.

The bankers are trying to get a windfall by using the debt hammer to achieve what warfare did in times past. They are demanding privatization of public assets (on credit, with tax deductibility for interest so as to leave more cash flow to pay the bankers). This transfer of land, public utilities and interest as financial booty and tribute to creditor economies is what makes financial austerity like war in its effect.

Socrates said that ignorance must be the root of all evil, because no one deliberately sets out to be bad. But the economic “medicine” of driving debtors into poverty and forcing the selloff of their public domain has become socially accepted wisdom taught in today’s business schools. One would think that after fifty years of austerity programs and privatization selloffs to pay bad debts, the world has learned enough about causes and consequences. The banking profession chooses deliberately to be ignorant. “Good accepted practice” is bolstered by Nobel Economics Prizes to provide a cloak of plausible deniability when markets “unexpectedly” are hollowed out and new investment slows as a result of financially bleeding economies, medieval-style while wealth is siphoned up to the top of the economic pyramid.

My friend David Kelley likes to cite Molly Ivins’ quip: “It’s hard to convince people that you are killing them for their own good.” The EU’s attempt to do this didn’t succeed in Iceland. And like the Icelanders, the Greek protesters have had their fill of neoliberal learned ignorance that austerity, unemployment and shrinking markets are the path to prosperity, not deeper poverty. So we must ask what motivates central banks to promote tunnel-visioned managers who follow the orders and logic of a system that imposes needless suffering and waste – all to pursue the banal obsession that banks must not lose money?

One must conclude that the EU’s new central planners (isn’t that what Hayek said was the Road to Serfdom?) are acting as class warriors by demanding that all losses are to be suffered by economies imposing debt deflation and permitting creditors to grab assets – as if this won’t make the problem worse. This ECB hard line is backed by U.S. Treasury Secretary Geithner, evidently so that U.S. institutions not lose their bets on derivative plays they have written up.

This is a repeat of Mr. Geithner’s intervention to prevent Irish debt alleviation. The result is that we enter absurdist territory when the ECB and Treasury insist on “voluntary renegotiation” on the ground that some bank may have taken an AIG-type gamble in offering default insurance or bets that would make it lose so much money that yet another bailout would be necessary. [1] It is as if financial gambling is economically necessary, not part of Las Vegas.

Why should this matter a drachma to the Greeks? It is an intra-European bank regulatory problem. Yet to sidestep it, the ECB is telling Greece to sell off its water and sewer rights, ports, islands and other infrastructure.

This veers on financial theater of the absurd. Of course some special interest always benefits from systemic absurdity, banal as it may be. Financial markets already have priced in the expectation that Greece will default in the end. It is only a question of when. Banks are using the time to take as much as they can and pass the losses onto the ECB, EU and IMF – “public” institutions that have more leverage than private creditors. So bankers become the sponsors of absurdity – and of the junk economics spouted so unthinkingly by the enforcers, cheerleaders for the banality of evil. It doesn’t really matter if their names are Trichet, Geithner or Papandreou. They are just kindred lumps on the vampire squid of creditor claims.

The Greek crowds demonstrating before Parliament in Syntagma Square are providing their counterpart to “Arab spring.” But what really can they do, short of violence – as long as the police and military side with the government that itself is siding with foreign creditors?

The most effective tactic is to demand a national referendum on whether to accept the ECB’s terms for austerity, tax increases, public spending cutbacks and selloffs. This is how Iceland’s President stopped his country’s Social Democratic leadership from committing the economy to ruinous (and legally unnecessary) payments to Gordon Brown’s Labour Party demands and those of the Dutch for the Icesave and even the Kaupthing bailouts.

The only legal basis for demanding payment of the EU’s bailout of French and German banks – and U.S. Treasury Secretary Tim Geithner’s demand that debts be sacrosanct, not the lives of citizens – is public acceptance and acquiescence in such policy. Otherwise the imposition of debt may be treated simply as an act of financial warfare.

National economies have the right to defend themselves against such aggression. The crowd’s leaders can insist that in the absence of a referendum, they intend to elect a political slate committed to outright debt annulment. Across the board, including the Greek banks as well as foreign banks, the IMF and EU central planners. International law prohibits nations from treating their own nationals differently from foreigners, so all debts in specified categories would have to be annulled to create a Clean Slate. (The German Monetary Reform of 1947 imposed by the Allied Powers was the most successful Clean Slate in modern times. Freeing the German economy from debt, it became the basis of that nation’s economic miracle.)

This is not the first such proposal for Greece. Toward the end of the 3rd century BC, Sparta’s kings Agis and Cleomenes urged a debt cancellation, as did Nabis after them. Plutarch tells the story, and also explains the tragic flaw of this policy. Absentee owners who had borrowed to buy real estate backed the debt cancellation, gaining an enormous windfall.

This would be much more the case today than in times past, now that the great bulk of debt is mortgage debt. Imagine what a debt cancellation would do for the Donald Trumps of the economy – having acquired property on credit with minimum equity investment of their own, suddenly owing nothing to the banks! The aim of financial-fiscal reform should be to free the economy from financial overhead that is technologically unnecessary. To avoid giving a free lunch to absentee owners, a debt cancellation would have to go hand in hand with an economic rent tax. The public sector would receive the land’s rental value as its fiscal base.

This happens to have been the basic aim of 19th-century free market economists: tax land and nature – and natural monopolies – rather than taxing labor and capital goods. The aim was to keep for the public what nature and public infrastructure spending create. A century ago it was believed that monopolies such as the privatizers now set their eyes should be operated by the public sector; or, if left in public hands, their prices would be regulated to keep them in line with actual costs of production. Where private owners already have taken possession of land, mines or monopolies, the rental revenue from such ownership privileges would be fully taxed. This would include the financial privilege that banks enjoy in credit creation.

The way to lower costs is to lower “bad” taxes that add to the price of production, headed by taxes on labor and capital, sales taxes and value-added taxes. By contrast, rent taxes collect the economy’s “free lunch,” and thus leave less available to be pledged to banks to capitalize into debt service on higher loans. Shifting the Greek tax burden off labor onto property would reduce the supply price of labor, and also reduce the price of housing that is being bid up by bank credit.

A land tax shift was the primary reform proposal from the 18th and 19th century, from the Physiocrats and Adam Smith down through John Stuart Mill and America’s Progressive Era reformers. The aim was to free markets from the landed aristocracy’s hereditary rents stemming from the medieval Viking conquest. This would free economies from feudalism, bringing prices in line with socially necessary costs of production.

Every government has the right to levy taxes, as long as they do it uniformly to domestic property owners as well as to foreign owners. Short of re-nationalizing the land and infrastructure, fully taxing its economic rent (access payments for sites whose value is created by nature or by public improvements) would take back for the Greek authorities what creditors are trying to grab.

This classical threat of 19th century reformers is the response that the Greeks can make to the European Central Bank. They can remind the rest of the world that it was, after all, the ideal of free markets as expressed from Adam Smith through John Stuart Mill in England, and underlay U.S. public spending, regulatory agencies and tax policy during its period of take-off.

How strange (and sad) that Greece’s own ruling Socialist Party, whose leader heads the Second International, has rejected this centuries-old reform program. It is not Communism. It is not even inherently revolutionary, or at least was not at the time it was formulated. It is socialism of the reformist type that two centuries of classical political economy culminated in.

But it is the kind of free markets against which the ECB is fighting – backed by Treasury Secretary Geithner’s shrill exhortations from the United States. Mr. Obama says nothing leaving it all to Wall Street bureaucrats to set national economic policy. Is this evil? Or is it just passive and indifferent? Does it make much of a difference as far as the end result is concerned?

To sum up, the aims of foreign financial aggression are the same as military conquest: land and the public domain. But nations have the right to tax their rental yield over and above a return to capital investment. Contrary to EU demands for “internal devaluation” (wage cuts) as a means of lowering the price of Greek labor to make it more competitive, reducing living standards is not the way to go. That reduces labor productivity while eroding the internal market, leading to a deteriorating spiral of economic shrinkage.

The need for a popular referendum

Every government has the right and indeed the political obligation to protect its prosperity and livelihood so as to keep its population at home rather than drive them abroad or drive them into a position of financial dependency on rentiers. At the heart of economic democracy is the principle that no sovereign nation is committed to relinquish its public domain or its taxing, and hence its economic prosperity and future livelihood, to foreigners or for that matter to a domestic financial class. This is why Iceland voted “No” in the debt referendum. Its economy is recovering.

Ireland voted “Yes” and now faces a new Great Emigration to rival that which followed the potato famine of the mid-19th century. If Greece does not draw a line here, it will be a victory for financial and fiscal aggression imposing debt peonage.

Finance has become the 21st century’s preferred mode of warfare. It’s aim is to appropriate the land and public infrastructure for its own power elites. Achieving this end financially, by imposing debt peonage on subject populations, avoids the sacrifice of life by the aggressor power – but only as long as subject debtor countries accept their burden voluntarily. If there is no referendum, the national economy cannot be held liable to pay the debts owed even to “senior” creditors: the IMF and ECB. Assets that are privatized at foreign bank insistence can be renationalized. And just as nations under military attack can sue, so Greece can sue for the devastation caused by austerity – the lost employment, lost output, lost population, capital flight.

The Greek economy will not end up with the proceeds of any ECB “bailout.” The banks will get the money. They would like to turn around and lend it out afresh to the buyers of the land, monopolies and other properties that Greece is being told to privatize. The user fees they collect (no doubt raising charges in the process, to cover the interest and pay themselves the usual salary jumps on privatized property) will be paid out as interest. Is this not like military tribute?

Margret Thatcher used to say “There is no alternative” (TINA). But of course there is. Greece can simply opt out of this giveaway of assets and economic privilege to creditors.

What do Mr. Papandreou’s Socialist International colleagues have to say about current events in Greece? I suppose it is clear that the old Socialist International is dead, given the fact that Mr. Papandreou is its head, after all. What passes for socialism today is the diametric opposite of the reforms promoted under its name a century ago, in the era prior to World War I. Europe’s Social Democratic and Labour parties have led the way in privatization, financializing their economies under conditions that have blocked the growth in living standards. The result promises to be an international political realignment.

Economic austerity cannot secure creditor claims in the end

On Thursday afternoon the DJIA, having been down 230 points, leapt up at the close to lose “only” 60 points, on rumors that Greece had agreed to the IMF’s austerity plan. But what is “Greece”? Is it the cabinet alone? Certainly not yet the entire Parliament. Will there be a Parliamentary vote in opposition to the public interest, accepting austerity and privatization?

Only a referendum can commit the Greek government to repay new debts imposed under austerity. Only a referendum can prevent property that is privatized from being re-nationalized. Such a transfer is not legitimate under commonly accepted ideas of political and economic democracy. And in any event, a rent-tax can recapture for the Greek economy what the financial aggressors are trying to seize.

History is rife with instructive examples. Local oligarchies in the region invited Rome to attack Sparta, and it overthrew the kings and their successor Nabis (who may himself have been royal). The sequel is that Rome headed an oligarchic empire, using violence at home to murder democratic reformers such as the Gracchi brothers after 133 BC, plunging the republic into a century of civil war. The creditor interests ended up fully in control, and their own banal self-seeking plunged the Western half of the Roman Empire into an economic and social Dark Age.

Let’s hope the outcome is better this time around. There will indeed be fighting, but more in the financial and fiscal sphere than the overtly military one. The fight ultimately can be won only by understanding the corrosive dynamics of the “magic of compound interest” and the social need to subordinate creditor interests to those of the overall “real” economy. But to achieve this, economic theory itself needs to be brought out of its current post-classical “neoliberal” banality.

[1] Louise Story, “Derivatives Cloud the Possible Fallout From a Greek Default,” The New York Times, June 23, 2011, quotes Christopher Whalen, editor of The Institutional Risk Analyst, as saying: “This is why the Europeans came up with this ridiculous deal, because they don’t know what’s out there. They are afraid of a default. The industry is still refusing to provide the disclosure needed to understand this. They’re holding us hostage. The Street doesn’t want you to see what they’ve written.”

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Thank you for comments and questions. Let me divide the responses into several different issues.

1. “Sustainability Conditions” for Government Deficits

I said: “If you want to take a guess at what our “mirror image” in the graph above will look like after economic recovery, I would guess that we will return close to our long-run average: a private sector surplus of 2% of GDP, a current account deficit of 3% of GDP and a government deficit of 5% of GDP. In our simple equation it will look like this:

Now I want to be clear, I said nothing to imply these particular sectoral balances would continue on through infinity to the sweet hereafter. What I gave was a contingent statement (what the balances would look like AFTER recovery and if we return to LONG-RUN AVERAGES—that is to say, average stances over the past 30 years or so, taking into account trends—essentially just eye-balling the 3 sectors graph provided in the blog). I have made no projection that we actually WILL recover, and it is certainly possible that even after recovery our private sector balance will remain in high surplus. Let us say it remains at 6% (which would be higher than average but consistent with an attempt to delever debt—that is, to keep consumption low in order to pay down debt). In that case, and again assuming the foreign balance remains a positive 3% (that is, our current account deficit is 3%) then the government will remain in deficit of 9% (more or less where it is now). I will not place probabilities on these two outcomes—I think the original statement is more likely—because my main point is simply that taking balances of each of the 3 sectors, the overall balance must be 0.

For those who would like to balance the government budget, the burden is on them to tell me what the implied outcome for the private and foreign sectors will be. If we are not going to return to the disastrous “Goldilocks” outcome with the private sector running deficits, then a huge adjustment will be necessary in the foreign balance in order to have a balanced government budget with a private sector surplus. Virtually none of the deficit hawks consider this. But, again, I would like to hear their explanation for how we will get the current account into surplus.

On to the sustainability conditions. It has become trendy among economist wonks to look at government budget stances to determine whether they could continue forever. Many objections could be raised to such purely mental exercises. An obvious one is that no government has ever lasted forever—and so any such exercise is a waste of time. Ok that one is not something we want to contemplate. Economist Herb Stein quipped that unsustainable processes will not be sustained. Something will change. That gets us somewhat closer to the problem with such approaches. And finally, if we are dealing with sovereign budget deficits we must first understand WHAT is not sustainable, and what is. That requires that we need to do sensible exercises. The one that the deficit hysterians propose is not sensible.

Let us first look at a somewhat simpler unsustainable process. Suppose that some guy—we’ll use the name Ramanan—decides to replicate the “Supersize me” experiment (based on the 2004 documentary by Morgan Spurlock). His caloric intake is 5000 calories a day, and he burns 2000 daily. The excess 3000 calories lets him gain one pound of body weight each day. If he weighed 200 pounds on January 1, by the end of the year he weighs 565 pounds. After 100 years he’s up to 36,700 pounds—a bit on the pudgy side. But we don’t stop there. After 100,000 years he weighs 36,700,000 pounds, and after a few million years, he’s heavy enough to affect the earth’s spin on its axis and its revolutions about the sun. But, according to our policy wonks, that still is not a long enough period—we’ve got to carry this out to infinity, at which point, Ramanan is infinite sized, like the universe, and if he is growing faster than the expansion of the universe, the entire rest of the universe will eventually be infinitesimally smaller than Ramanan. I guess he’s become the black hole of the universe (but I’m no physicist or biologist). So, yes this is unsustainable. Aren’t we all clever?

But would the process actually work that way? Of course not. First, Ramanan is not going to live an infinite number of years; second, he’s either going to blow up (literally) or go on a diet; and third, and most important, his body is going to adjust. As his body mass increases, he will burn more than 2000 calories a day—perhaps he’ll get up to a 5000 calorie a day burn-rate—and his body will use the food in a less efficient manner. So he will stop gaining weight long before he becomes the universe’s black hole. Herb Stein was right.

Our little mental exercise was fundamentally flawed. It assumed a fixed caloric input (flow) and a fixed caloric burn-rate (consumption flow) with the difference between the two accumulating as a stock (weight gain) at a fixed rate (essentially, “savings”). No adjustments to behavior or metabolism are allowed. And then the whole absurd set-up is carried to the ultimate absurdity by the use of infinite horizon projections. Anything carried to a logical absurdity is unsustainable. As you will see, this is the rigged game used by deficit warriors to “prove” the US Federal budget deficit is unsustainable.

The trick used by deficit warriors is similar but with the inputs and outputs reversed. Rather than caloric inputs, we have GDP growth as the input; rather than burning calories, we pay interest; and rather than weight gain as the output we have budget deficits accumulating to government debt outstanding. To rig the little model to ensure it is not sustainable, we have the interest rate higher than the growth rate—just as we had Ramanan’s caloric input at 5000 calories and his burn rate at only 2000—and this will ensure that the debt ratio grows (just as we ensured that Ramanan’s waistline grew without limit). Let us see how this works.

We will start with a simple example similar to the one used in our blog and response last week. Let us have two sectors, government and private. Our government follows the Goldilocks model, spending less than its income (tax revenue); the private sector by identity runs a deficit (spends more than its income). We know this means the private sector is running up debt, held by the government as its asset (surpluses are realized in the form of private sector IOUs). The private sector must service the debt by paying interest; that of course adds to its deficit (interest is additional spending it must make out of its income). In comparison to our Supersizing Ramanan, the sustainability conditions will be determined by the interest rate paid, the growth rate of income (or GDP), and the deficit of the private sector.

Jamie Galbraith laid out the typical model used to evaluate sustainability of deficit spending as follows:

The key formula is:

Δd = –s + d * [(r – g)/(1 + g)]

Here, d is the starting ratio of debt to GDP, s is the “primary surplus” or budget surplus after deducting net interest payments (as shares of GDP), r is the real interest rate, and g is the real rate of GDP growth. (http://www.levyinstitute.org/publications/?docid=1379)

Now, this is wonky but the key idea is that (given a relation between the primary surplus and starting debt–both as ratios to GDP) so long as the interest rate (r) is above the growth rate (g) the debt ratio is going to grow. (Jamie has put these key terms in “real”—that is inflation adjusted—terms but that really does not matter; we can keep it all in nominal terms since “deflation” by the inflation rate merely reduces all terms by the inflation rate). Note that the starting debt ratio (d) as well as the primary surplus (what the private sector’s budget would be if it did not have to pay interest) also play a role. (Galbraith proves that the starting debt ratio does not matter much—just as Ramanan’s initial weight will not matter since in any case he will grow to an infinite size.) But we do not need to get too hung up in math to see that all things equal if the interest rate is above the growth rate, we get a rising debt ratio. If we carry this through eternity, that ratio gets big. Really big. Ok that sounds bad. And it is. Remember, that is a big part of the reason that the GFC hit—overindebted private sector. The GFC is the equivalent to an explosion of Ramanan that would prevent him from growing to an infinite size. (A debt diet would have been far preferable, but Greenspan and Bernanke opposed “interfering” with Wall Street lender fraud.)

Now let us change all this around. Let us say that the government runs a continuous budget deficit while the private sector runs a surplus. We can obtain the same equation. It appears that a continuous government budget deficit implies a continuously rising debt to GDP ratio and surely that is unsustainable. (See the appendix below for more complex math.)

But wait a minute. Is such a mental exercise sensible? We already saw that our supersizing Ramanan is going to adjust: he will diet, explode, increase his metabolism, and reduce the efficiency of his absorption of calories. If he does not explode, he will reach some “equilibrium” in which his intake of calories will equal his burn-rate so that his waistline will stop growing. What about our supersizing government? Here are the possible consequences of a persistent deficit that implies rising interest payments and debt ratios:

Inflation: this tends to increase tax revenues so that they grow faster than government spending, thus lowering deficits. (Many, including Galbraith, would point to the tendency to generate “negative” interest rates.) In other words the growth rate will rise above the interest rate, and reverse the dynamics so that the debt ratio stops growing. (That is equivalent to an increase of Ramanan’s caloric burn rate—so he stops growing.)

Austerity: government can try to adjust its fiscal stance (increasing taxes and reducing spending to lower its defict). Of course, it takes “two to tango”—raising tax rates might not change the government’s balance. It could lower growth rates, and thereby actually increase the rate of growth of the debt ratio.

The private sector will adjust its flows (spending and saving) in response to the government’s stance. If government continually spends more than its income, it will be adding net wealth to the private sector; and its interest payments will add to private sector income. It is not plausible to believe that as the government’s debt ratio goes toward infinity (which means that the private sector’s net wealth ratio goes to infinity) there is no induced spending in the private sector. That is usually called the “wealth effect”. In other words, government debt is private wealth and as private wealth grows without limit this will eventually cause spending to rise relative to private sector income—reducing government deficits. In addition, private sector income includes government interest payments, so rising government interest payments on its debt could induce consumption. When all is said and done, the private sector will not be happy consuming less than its income flow—given its rising wealth—and will adjust its saving behavior. If the private sector tries to reduce its surpluses, this can be done only by reducing the government sector’s deficits. It takes two to tango and the likely result is that tax revenues and consumption will rise, the government’s deficit will fall, and the private sector’s surplus will fall.

Government deficit spending and interest payments could increase the growth rate; it can be pushed above the interest rate. This changes the dynamics and can stop the growth of the debt ratio.

The interest rate is a policy variable (as will be discussed in subsequent weeks). Ignoring all the dynamics discussed in the previous points, to avoid an exploding debt ratio, all the government needs to do is to lower the interest rate below the economic growth rate. End of story, sustainability achieved.

Finally, and this is the most contentious point. Suppose none of the dynamics just discussed come into play, so the government’s debt ratio rises on trend. Will a sovereign government be forced to miss an interest payment—no matter how big that becomes? The answer is a simple “no”. It will take weeks of explication of MMT to explain why. But let us put this in the simple terms that Chairman Bernanke used to explain all the Fed spending to bail-out Wall Street: government spends using keystrokes, or, electronic entries on balance sheets. There is no technical or operational limit to its ability to do that. So long as there are keyboard keys to stroke, government can stroke them to produce interest payments credited to balance sheets.

And that finally gets us to the difference between perpetual private sector deficit spending versus perpetual government sector deficits: the first really is unsustainable while the second is not. Now, I want to be clear. We have argued that persistent government budget deficits that increase government debt ratios and thus private wealth ratios will lead to behavioral changes. They could lead to inflation. They could lead to policy changes. Hence, they are not likely to last “forever”. So when I say they are “sustainable” I merely mean in the sense that sovereign government can continue to make all payments as they come due—including interest payments—no matter how big those payments become. It might choose not to make those payments. And the mere act of making those payments will likely cause changes in growth rates and budget deficits and growth of debt rations.

2. “Sustainability” of Current Account ratios:

In the quote at the top of this response there was also a contingent statement about US current account deficits. To be more clear (and thus to respond to comments), the current account includes the balance of trade (and, more broadly, the balance between exports and imports) plus some other items including “factor payments” (interest and profits paid and received). For the US, we obviously run a trade deficit (and exports are less than imports), but the factor payments are in our favor (we receive more in profits and interest from abroad than we pay to foreign creditors and owners). In any event, our negative current account balance is offset by a positive capital account balance. To put it simply—there is a “flow” of dollars abroad due to the current account deficit that is matched by the “flow” of dollars back to the US due to our capital account surplus. This is often (misleadingly) presented as US “borrowing” of dollars to “pay for” our trade deficit. We could just as well put it this way: the US imports more than it exports because the rest of the world wants to accumulate savings in dollar-denominated assets. I do not want to go into that in detail since it is the subject of later blogs.

But here’s the question. Is a continuous current account deficit possible? A simple answer is yes, so long as “two want to tango”: if the rest of the world wants dollar assets and Americans want rest of world exports (imported to the US), this will continue. But, hold it, say the worriers. As the rest of the world accumulates dollar claims on the US, they also receive interest payments. That is a factor payment that increases our current account deficit. You can see the relation to the point above about government deficits and interest payments. The world will be flooded with dollars twice over: once from our excessive propensity to import and once from our interest payments on debt.

But here is the interesting point: even though the US is the “biggest debtor on earth”, those factor payments flow in our favor. We pay extremely low interest rates and profit rates to foreigners, and earn much higher interest rates and profits on our holdings of foreign investments and debt. Why is that? Because the US is the safest investment on earth. Anytime there is a financial crisis anywhere in the world, where do international investors run? To the US dollar. Ironically, that happens even when the crisis begins in the US! Why? The US has a sovereign government with a sovereign currency. Its interest rate is set by the Fed, which can always set the rate below the US growth rate (and, indeed, as Galbraith points out, the inflation-adjusted interest rate is often below the “real” growth rate). In spite of the deficit hysteria whipped up by hedge fund billionaire Pete Peterson, no investor in her right mind believes there is any default risk on US Treasury debt. So when global fears rise, investors run to the dollar. This could change, but not in your lifetime.

In short, I make no projection about continued US current account deficits but I believe they will continue far longer than anyone imagines. They are sustainable. They will be sustained until the rest of the world decides not to accumulate more dollars and Americans decide they really do not want the cheap junk and environment-destroying oil produced by the rest of the world. When that will happen, I do not know. It is nothing to lose sleep over. Yes we can calculate “sustainability conditions” but it would just be an exercise in mental masturbation. We’ve already done enough of that. I suppose it is titillating but ultimately unsatisfying.

3. Briefly there were several other points raised.

There were some about maldistribution of income as a contributing cause of the private sector deficit. Agreed. There were some questions about stocks and relations to flows. Some of that is treated above but much more will come in the next series of blogs. There were points made about need to regulate Wall Street. Yes! There were questions about QE and the difference between helicopter drops and fiscal policy. Put it this way: Treasury SPENDS money things into existence, the Fed LENDS money things into existence. The first adds income and net wealth, the second only transforms balance sheets. This will be explained in more detail later.

Appendix:

Government debt outstanding (D) follows the following law of motion:

That is, every year, assuming the debt never matures, the outstanding debt increases by the size of the deficit. The deficit is the difference between government spending (G), taxes (T) plus interest payments on outstanding debt (iD)

Let us assume to simplify that G = T so: therefore

The gross domestic product (Y) grows at a rate g and so follows the following law of motion:

Let us find the limit of this ratio:

Following the same logic for Y we get (noting d the debt to gdp ratio)

It is pretty clear that if i > g then the ratio tends toward infinity when n tends toward infinity; and toward zero otherwise. If g = i then dt = d0 for all t.

The complication of the deficit to GDP ratio at 5% would mean:

Without going too far into the implications we have:

Therefore by doing a recursive calculation we get:

As n tends toward infinity dt also does. Note that a given deficit to gdp ratio means that deficit has to explode as gdp increases.

Mitt Romney chose to unveil the economic plank of his campaign for the Republican nomination with a speech in Aurora, Colorado decrying banking regulation. He could not have picked a more symbolic location to make this argument, for Aurora is the home and name of one of the massive financial frauds that caused the Great Recession. Lehman Brothers’ collapse made the crisis acute and Lehman’s subsidiary, Aurora, doomed Lehman Brothers. Lehman acquired Aurora to be its liar’s loan specialist. The senior officers that Lehman put in charge of Aurora, which was inherently in the business of buying and selling fraudulent loans, set its ethical plane at subterranean levels.

Aurora sealed Lehman’s fate by serving as a “vector” that spread an epidemic of mortgage fraud throughout the financial system and caused catastrophic losses far greater than Lehman’s entire purported capital. Aurora epitomizes what happens when we demonize the regulators and create regulatory “black holes.” Romney literally demonized banking regulators as “gargoyles” and claimed that banking regulations and regulators were the cause of the economy’s weak recovery.

On April 20, 2010, I testified before the Committee on Financial Services of the United States House of Representatives regarding Lehman’s failure. I was the witness chosen by the (then) Republican minority because they wished to have testimony from an experienced and successful financial regulator who would pull no punches in critiquing the failures of the Federal Reserve Bank of New York (FRBNY), the Board of Governors of the Federal Reserve (the Fed), and the Securities and Exchange Commission (SEC) with regard to Lehman. The Republicans’ target was the former President of the FRBNY, Timothy Geithner.

My House testimony explained why Aurora was the key to understanding Lehman’s failure and the causes of the financial crisis.

Lehman was a “control fraud.” That is a criminology term that refers to situation in which the persons controlling a seemingly legitimate entity use it as a “weapon” (Wheeler & Rothman 1982) of fraud (Black 2005). Financial control frauds’ “weapon of choice” for looting is accounting.

Lehman’s nominal corporate governance structure was a sham. Lehman was deliberately out of control with regard to “risk” in its dominant operation – making “liar’s loans.” Lehman did not “manage” the risk of making liar’s loans. It engaged in massive, fraudulent transactions that were “sure things” (Akerlof & Romer 1993). The Valukas Report … provides further evidence of the accuracy of George Akerlof and Paul Romer’s famous article – “Looting: Bankruptcy for Profit.” The “looting” that Akerlof & Romer identified is a “sure thing” in both directions – firms that loot through accounting scams will report superb (fictional) income in the short-term and catastrophic losses in the long-term.

The value of Lehman’s Alt-A mortgage holdings fell 60 percent during the past six months to $5.9 billion, the firm reported last week.[1]

This roughly $9 billion loss, in 2008, was an important factor in destroying Lehman, but it represents only losses on liar’s loans still held in portfolio. Aurora specialized in making liar’s loans and Aurora’s loans caused massive losses because they were pervasively fraudulent. Lehman sold tens of billions of dollars of liar’s loans through Aurora and a subsidiary (BNC Mortgage) that specialized in making subprime loans – roughly half of which were liar’s loans by 2006. The purchasers of these fraudulent loans had the legal right and economic incentive to require Lehman to repurchase the loans, which would have far exceeded Lehman’s reported capital. Making and selling fraudulent liar’s loans doomed Lehman. Lehman was one of the largest vectors that spread fraudulent mortgage paper throughout much of Europe and the United States.

Lehman had become the only vertically integrated player in the industry, doing everything from making loans to securitizing them for sale to investors.

***

Lehman was a dominant player on all sides of the business. Through its subsidiaries – Aurora, BNC Mortgage LLC and Finance America – it was one of the 10 largest mortgage lenders in the U.S. The subsidiaries fed nearly all their loans to Lehman, making it one of the largest issuers of mortgage-backed securities. In 2007, Lehman securitized more than $100-billion worth of residential mortgages.

These demands posed a much larger problem: contagion. Because these CDOs were thinly traded, many of them did not yet reflect the loss in value implied by their crumbling mortgage holdings. If Bear Stearns or its lenders began auctioning these CDOs off, and nobody wanted to buy them, prices would plummet, requiring all banks with mortgage exposure to begin adjusting their books with massive writedowns.

Lehman, despite its huge mortgage exposure, appeared less scathed than some. Mr. Fuld was awarded $35-million in total compensation at the end of the year.

The volume of liar’s loans and subprime loans was everything – as long as Lehman could sell the liar’s loans to other parties. Volume created immense real losses, but it also maximized Dick Fuld’s compensation. Nonprime loans drove Lehman’s (fictional) gains in income and capital under Fuld.

Lehman’s real estate businesses helped sales in the capital markets unit jump 56 percent from 2004 to 2006, faster than from investment banking or asset management, the company said in a filing. Lehman reported record earnings in 2005, 2006 and 2007.

As MARI, the mortgage lending industry’s own anti-fraud experts, warned the industry in 2006, making liar’s loans is an “open invitation to fraudsters.” Even Lehman’s internal studies found, by reviewing only the loan files, exceptional levels of fraud.

Mark Golan was getting frustrated as he met with a group of auditors from Lehman Brothers.

It was spring, 2006, and Mr. Golan was a manager at Colorado-based Aurora Loan Service LLC, which specialized in “Alt A” loans, considered a step above subprime lending. Aurora had become one of the largest players in that market, originating $25-billion worth of loans in 2006. It was also the biggest supplier of loans to Lehman for securitization.

Lehman had acquired a stake in Aurora in 1998 and had taken control in 2003. By May, 2006, some people inside Lehman were becoming worried about Aurora’s lending practices. The mortgage industry was facing scrutiny about billions of dollars worth of Alt-A mortgages, also known as “liar loans”– because they were given to people with little or no documentation. In some cases, borrowers demonstrated nothing more than “pride of ownership” to get a mortgage.

That spring, according to court filings, a group of internal Lehman auditors analyzed some Aurora loans and discovered that up to half contained material misrepresentations. But the mortgage market was growing too fast and Lehman’s appetite for loans was insatiable. Mr. Golan stormed out of the meeting, allegedly yelling at the lead auditor: “Your people find too much fraud.”

After the FBI warned in September 2004, that there was an “epidemic” of mortgage fraud, after Lehman’s internal auditors found endemic fraud in their liar’s loans, after MARI warned the industry in 2006 that studies of liar’s loans found a fraud incidence of 90%, after the bubble had stalled in 2006, and after scores of mortgage banks that specialized in making nonprime loans failed – Lehman significantly increased the rate at which Aurora made liar’s loans. In 2006, Aurora originated roughly $2 billion a month.

BNC was Lehman’s subsidiary that specialized in subprime loans. By 2006, roughly half of its loans were liar’s loans to borrowers with poor credit records.

Lehman’s pattern of conduct seems bizarre because no honest firm would make liar’s loans. The pattern, however, is optimal for an accounting control fraud. The people who control fraudulent lenders optimize their compensation by maximizing the bank’s short-term reported income. The “recipe” for maximizing fictional income (and real losses) has four ingredients:

The officers controlling a fraudulent lender find it necessary to eviscerate the bank’s underwriting in order to be able to make large amounts of bad loans. The managers deliberately create a fraud-friendly culture, and Aurora demonstrated how extreme the embrace of fraud could become.

The HR lady pulled Michael Walker into a room and told him he was fired.

The reason: Talking to the FBI. It was a violation of the company’s privacy policy.

Walker, a “high-risk specialist,” was then walked out of the building as if he were the risk. His job at Aurora Loan Services LLC, Littleton, Colo., ended on Sept. 4, 2008.

His job was to uncover mortgage fraud. But he claims he was fired for doing it. In a lawsuit recently filed in Denver District Court, he claims Lehman’s mortgage subsidiary wanted to remain profitably unaware of fraud.

Aurora [personnel] got paid by loan volume, not by loan quality.

Consequently, Walker and his fraud-seeking colleagues were always busy.

“They just absolutely flooded us with work,” he said. “There was no way we could possibly keep up with it. And that’s what they wanted.

“They were putting the loans into an investment trust,” he explained. “When they became aware of fraud, they had to buy those loans back out of the trust. So it ended up costing them money.”

But Walker couldn’t play this game. A “Suspicious Activity Report” that he filed in 2006 led to interviews with the FBI and the IRS in 2008, and then ultimately to his bizarre dismissal.[2]

Lehman’s senior managers consciously chose to take the unethical path because they knew it generate extraordinary reported income in the short-term, which would maximize their compensation. Prior to becoming one of the world’s largest purchasers and sellers of nonprime loans through Aurora and BNC, Lehman had eagerly embraced fraudulent and predatory lending. The officers who controlled Lehman also showed in this earlier episode that they would choose that short-term reported income that maximized their compensation even when they were warned that it was produced by fraud and abuse of the customers and knew that the loans would produce large losses,

Mr. Hibbert was a vice-president at Lehman Brothers and he’d been sent to meet First Alliance founder Brian Chisick to see if Lehman could form some kind of relationship with the mortgage lender.

[Hibbert] pointed out that “there is something really unethical about the type of business in which [First Alliance] is engaged.”

Mr. Chisick had become one of the biggest players in subprime loans. First Alliance’s annual revenue had doubled in four years to nearly $60-million (U.S.) and its profit had increased threefold to $30-million.

“It is a sweat shop,” [Hibbert] wrote. “High pressure sales for people who are in a weak state.” First Alliance is “the used car salesperson of [subprime] lending. It is a requirement to leave your ethics at the door. … So far there has been little official intervention into this market sector, but if one firm was to be singled out for governmental action, this may be it.”

Despite the warning, Lehman officials recommended a $100-million loan facility for First Alliance. Mr. Chisick turned it down, but he agreed to take a $25-million line of credit and hire Lehman to work with Prudential on several securitizations.

At this juncture, Hibbert’s warnings of a governmental response proved accurate. Various state Attorneys General began to sue First Alliance for consumer fraud. Prudential terminated its ties with the lender.

But Lehman jumped at the opportunity to move in. Senior vice-president Frank Gihool asked Mr. Hibbert to pull together a review of First Alliance for Lehman’s credit risk management team. Mr. Hibbert once again marvelled at the company’s operations and financial outlook. But he also said the lawsuits posed a serious problem. The allegation about deceptive practices “is now more than a legal one, it has become political, with public relations headaches to come,” he wrote.

Nonetheless, on Feb. 11, 1999, Lehman approved a $150-million line of credit, and became the company’s sole manager of asset-backed securities offerings. The bottom line for Lehman was made clear in another internal report: The firm expected to earn at least $4.5-million in fees.

But within a year, the weight of the lawsuits crippled First Alliance. On March 23, 2000, the company filed for bankruptcy protection. Mr. Chisick managed to walk away with more than $100-million in total compensation and stock sales over four years. Lehman, owed $77-million, collected the full amount, plus interest.

First Alliance eventually settled the lawsuits filed by the state attorneys, agreeing to pay $60-million. In the California class-action case, a jury found Lehman partially responsible for First Alliance’s conduct and ordered the firm to pay roughly $5-million.

Romney is Echoing the Anti-regulatory Dogma that Caused the Crisis

Aurora and BNC Mortgage were regulatory “black holes.” The Fed had unique authority under the Home Ownership and Equity Protection Act of 1994 (HOEPA) to regulate all mortgage lenders and had unprecedented practical leverage during the crisis because of its ability to lend to investment banks and convert them to commercial bank holding companies. Fed Chairmen Greenspan and Bernanke, despite pleas from Dr. Gramlich, refused to use this authority to close the regulatory black hole. Bernanke finally, under repeated pressure from Congressional Democrats, used the Fed’s HOEPA authority in August 2008 – over a year too late to even minimize losses. Greenspan and Bernanke were chosen to lead the Fed because of their intense, anti-regulatory dogma. Greenspan was notorious for his assertion that fraud provided no basis for regulation. He believed that financial markets automatically excluded fraud.

The SEC was equally notorious for its anti-regulatory policies. It created the disgraceful non-regulation regulation of Lehman and its four sister investment banks. The Consolidated Supervised Entities (CSE) program never made the SEC a real “primary regulator.” The SEC is incapable, as constituted, staffed, and led to be a primary regulator of anything – and that includes the rating agencies. “Safety and soundness” regulation is a completely different concept than a “disclosure” regime. The SEC’s expertise, which it has allowed to rust away for a decade, is in enforcing disclosure requirements. The SEC did not have the mindset, rules, or appropriate personnel to make the CSE program a success even if the agency had been a “junk yard dog.” Given the fact that the SEC was self-neutered by its leadership during the period Lehman was in crisis in 2001-2008, there was no chance that it would succeed even if the CSE been a real program.

The reality is that the CSE was a sham. The EU announced that it would begin regulating foreign investment banks doing business in the EU unless they were subject to consolidated supervision by their domestic regulator. The U.S., however, had no consolidated supervision of investment banks. The five largest U.S. investment banks were scared of the prospect of EU regulation. Their solution was for the SEC to create a faux regulatory system. The SEC assigned three staffers to be primarily responsible for each of the five, massive investment banks. In order to examine and supervise an entity of their size and complexity, a realistic staff level would begin at 150 regulators per investment bank.

The SEC’s only hope with respect to Lehman was to form an effective partnership with the Fed. An SEC/Fed partnership would at least have some chance. The Valukas report reveals that the FRBNY staff at Lehman recognized that the SEC’s staff at Lehman’s offices was not capable of understanding its financial condition.

Why we suffered the Great Recession and such a slow recovery

The primary cause of severe bank failures has long been senior insider fraud (James Pierce, The Future of Banking (2001). We know the characteristics that cause the criminogenic environments that produce the epidemics of accounting control fraud that cause our recurrent, intensifying crises. Two of the most important factors are the “three de’s” – deregulation, desupervision, and de facto decriminalization – and perverse executive, professional, and employee compensation. These two factors were principally responsible for creating the epidemic of mortgage fraud that drove our crisis. Financial regulation was effectively destroyed in the U.S.

The primary function of financial regulators is to serve as the “regulatory cops on the beat.” “Private market discipline” was an oxymoron – financial firms are supposed to provide the discipline by denying credit to poorly managed and overly risky firms. They are supposed to be impervious to fraud. The reality is that they fund the frauds’ rapid growth. Fraud begets fraud. George Akerlof warned of this perverse “Gresham’s” dynamic in his famous 1970 article about “lemon’s” markets. When fraud provides a competitive advantage market forces become perverse and drive ethical firms from the marketplace. Effective, vigorous financial regulation is essential to break this Gresham’s dynamic. The regulatory cops on the beat must take the profit out of fraud.

There are several reasons why the economic recovery is weak and there is a great danger of recurrent recessions. My colleagues on this blog have explained the macroeconomic reasons so I will concentrate on the regulatory barriers to recovery. Suffice it to say that my colleagues have shown that the recovery is not weak primarily due to credit restraints by banks on lending to corporations. The regulatory barriers to recovery are the opposite of what Romney asserts. Financial regulation in the U.S. remains extraordinarily weak. President Obama has largely kept in power and even promoted Bush’s financial wrecking crew. Larry Summers and Timothy Geithner are fierce anti-regulators. The Republicans have blocked vital appointments to the Fed – under the claim that a Nobel Prize winner in economics lacks sufficient expertise to serve on the Fed. The Republicans, while claiming that Fannie and Freddie pose a critical risk to the nation; have blocked the appointment of a superbly qualified head of the agency that is supposed to regulate Fannie and Freddie. The Republicans have blocked the appointment of Elizabeth Warren to head the Consumer Finance Protection Bureau. Warren (a) warned of the coming nonprime disaster, (b) is superbly qualified to lead the bureau, and (c) is a remarkably pleasant and unassuming Midwesterner. The head of the SEC was named based on her experience as a failed leader of self-regulation. Bernanke named as the Fed’s top supervisor an anti-regulatory economist with no experience in examination or supervision. Bernanke then, absurdly, claimed that his appointment made the agency more inter-disciplinary. The reality is that it simply made theoclassical economists dominant in the one senior professional post that previously provided the Fed with an alternative policy perspective and real expertise. Attorney General Holder has largely continued the Bush administration’s policy of allowing the elite bank frauds to proceed with impunity.

The Republicans are trying to force severe cuts in the already inadequate budgets of the financial regulatory agencies. The flash clash revealed that the SEC does not have the internal capacity to monitor or even study retrospectively hyper-trading, which has become increasingly dominate. The SEC will not be provided with sufficient budget to even develop a system to monitor and study hyper-trading. The commodity markets are being subjected to exceptional manipulation. The Commodities Futures Trading Commission (CFTC) has announced that it cannot afford to develop the systems essential to detect and track commodity speculation. Instead of demanding that the CFTC develop such an essential system the Republicans are seeking to slash the CFTC’s already grossly inadequate budget.

Romney’s claim that this group of understaffed and funded regulators led by senior anti-regulators constitutes “gargoyles” that have terrified the systemically dangerous institutions (SDIs) that dominate our finance system is ludicrous. There isn’t an SDI in the U.S. that fears its regulators. The regulators are like gargoyles – they may scare children but one soon learns that they are immobile stones that do not see, bite, or even growl. They are perches and canvasses for pigeons and their droppings.

Epidemics of accounting control fraud cause severe economic crises and harm recoveries in myriad ways. First, fraud causes far more severe losses. Second, fraud erodes trust because the essence of fraud is the creation and betrayal of trust. Trust can take many years to recover. The number of middle class Americans willing to invest in the stock market has still not recovered from the Enron era frauds. Third, as Akerlof & Romer (1993) warned, accounting control fraud epidemics can cause bubbles to hyper-inflate. Severe bubbles make markets grossly inefficient. Japan demonstrates that it can take over a decade for the prices to fall to levels where the markets will “clear.” The catastrophic nature of the losses and their concentration in financial institutions leads to the temptation to change the accounting rules to cover up the banks’ losses. We refused to do so during the S&L debacle and the result was a prompt recovery. We, like Japan, gave in to the banks’ demands during this crisis and the result is an impaired recovery. Fourth, the endemic mortgage fraud by lenders led to endemic foreclosure fraud because fraudulent lenders (a) keep extremely poor records and (b) a number of the largest servicers are staffed with personnel from the firms that made the fraudulent loans. The foreclosure fraud is harmful both because it defrauds the innocent and because it shields the most abusive borrowers from prompt foreclosures. Fifth, the fraud and the hyper-inflated bubble lead to a severe drop in private wealth and demand and household pessimism. The household sector has not been able to provide the demand to produce a strong recovery. Sixth, because we pretend that insolvent banks are healthy and keep them under the leadership of the inept and even fraudulent managers who caused them to become insolvent we end up with Japanese-style crippled banks that prefer to clip coupons rather than make commercial loans.

Romney is replaying the absurd and harmful propaganda of 1986-1987. S&L regulation was critically weak, which is what made the S&L industry so criminogenic. The industry trade association, however, claimed that regulation was oppressive. We, the S&L Federal Home Loan Bank Board Chairman Edwin Gray with any funds and any additional regulatory powers to counter the accounting control frauds that were running wild. Instead, in the Competitive Equality in Banking Act of 1987 (CEBA), Congress mandated “forbearance” designed to gut our power to close the frauds. This was not Congress’ intent – they did not consciously seek to aid the frauds. The worst S&L frauds, however, formed what a prominent CEO called a “Faustian bargain” with the S&L trade association to counter our proposed legislation. The result of that Faustian bargain was that language was inserted in our proposed bill that was framed by the frauds’ lobbyists for the express purpose of making it far more difficult for us to close the frauds. Until we took on their political patrons and spent months explaining to members of Congress, their staffs, and the media how the proposed amendments would damage our ability to act effectively against the frauds these claims that the regulators were ogres were taken as true by most politicians. All their political contributors said it was true. The reality was, of course, the opposite as virtually everyone now agrees. S&L regulation had been nearly non-existent. With the aid of Representatives Gonzalez, Leach, Carper, and Roemer and Senator Gramm (yes, that Senator Gramm!) we were able to make subtle changes in the CEBA bill that undid the worst of the frauds’ amendments.

Will the Obama administration be willing to fight like we did to save the effort to put the fraudulent S&Ls in receivership, remove the scam accounting rules, toughen regulation, and prosecute the fraudulent senior officers? Or will it give in to Romney’s propaganda and its desire to raise vast sums in political contributions from finance executives by weakening the already criminally weak Dodd-Frank Act? The administration’s most recent action has been to delay adoption of the rules implementing the Act. It wants banks to be able to continue the disastrous practices that made the crisis worse and that the Dodd-Frank Act sought to prohibit.

Here are the key passage and question arising from Romney’s speech:

“Almost everything the president did had the opposite effect of what was intended,” Romney said. “He said, okay, we’re not going to re-regulate the banking sector. Well, what he caused was the banking sector to pull back, and that’s the very sector that’s got to step forward to help get the economy on its feet again.”

The question to President Obama is: “Was Mr. Romney correct when he said that you decided not to ‘re-regulate the banking sector’?” And the follow-up question, if your answer is “yes” is: “If the Great Recession and the epidemic of bank fraud is not sufficient for you to reregulate the banking sector – what will it take?” Secretary Geithner and Chairman Bernanke state that the unregulated banking sector caused catastrophic losses and, but for extraordinary government intervention, would have caused the Second Great Depression. Effective banking regulation is essential to protect the public and honest banks. Both parties’ economic policies, however, are dominated by theoclassical economic dogma. Breaking the death grip of this criminogenic dogma on theory and policy is the economic profession’s most pressing need. Economists, and the politicians who find parroting their anti-regulatory policies so useful in raising campaign contributions, are the greatest threat to the economy.